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July 2, 2010

"An Unfair Advantage"? Combining Banking with Private Equity Investing

"Does the combination of banking and private equity investing endow banks with superior information that allows them to identify good prospects and garner superior returns?" asks Lily Fang, Victoria Ivashina, and Josh Lerner from HBR. "Or does the combination bestow banks with an unfair ability to expand their balance sheets, capturing benefits within the bank at the expense of the overall market and ultimately the taxpayers?"
When I first went to meet with all of Canada's Private Equity players, I quickly learned that Canada's banks had tried doing private equity, but have exited this industry. The main reason is that the Bank culture is very different from Private Equity. Banking is about managing risk, while private equity culture requires embracing higher risk than most could stomach.
It reminds me of General Stanley McChrystal's situation who was reported in Rolling Stone to have made insubordinate comments about the USA government. Many of these comments, such as "Bite Me", I have heard a million times from very senior men during my career in finance. 
Many have condemned the General for being light with his criticisms of the top leadership of the USA in front of a reporter. Yet, they would probably mostly agree that McChrystal is very smart and good at his work -cutting edge, in fact. Those criticizing McChrystal would probably even agree that his innovations have reinvented the US military. That is quite an accomplishment for a man who has now been fired for criticizing his boss in the media.
If you did a quick survey, I predict that those who think McChrystal should be fired for his insubordinate (and foolish) remarks are usually working for big companies. They can not fathom making such comments to any media, even a music magazine. I suspect that McChrystal probably thought Rolling Stone would be empathetic to his coolness and repaint the military as a hip place to be, after the Bush years of ridicule. 
Business owners and private equity would be more likely to say McChrystal should have been reined in, but certainly not have lost his job. Private equity and entrepreneurs look past these terse, sarcastic jokes and appreciate if the job is being done very well. Private equity would first ask and look for the answer "yes" to every question:

  • Is this warrior of top value to building the military of the future?
  • Is this person an innovator? 
  • Is he bringing more to the bottom line even as he grates? 
  • Does this person challenge authority, but is there value in what he is saying? 
  • Could we bring him in and coach him more on how to keep the team working together, and encourage a little less of the Clint Eastwood shots from the corner of the room? 

OK then. You have a good person here, but with a badly misguided PR problem. 
General McChrystal is operating in a very different world than most corporate people. His world requires entrepreneurial thinking and attitude to challenge sacred cows. I can guarantee that corporate behaviour is not going to save lives and it is why the US military has been spinning its wheels because they stifle their true warriors. 
McChrystal's brashness  is his value. His riskier behaviour is change agent behaviour. When the leadership takes out their innovators, a bad message goes out to the rest of the military strategists. Think, but do not speak your mind. It is why innovation does not happen in big corporates. the rest of the people will not stand for it. They stamp it out viciously. 
General McChrystal demonstrates private equity behaviour. His boss, General David Petraeus, is steady at the wheel type of fellow, who tows the line, illustrates more bank relevant culture. And that - in a military story - is why banks should not do private equity.

Read more: 
  Read more at Harvard's excellent article on this: 

INSEAD's Lily Fang and Harvard Business School professors Victoria Ivashina and Josh Lerner examined nearly 8,000 unique private equity transactions between 1978 and 2009, looking in depth at the nature of the private equity investors, the structure of the investments, and the performance of the firms. Collectively, findings suggest that there are risks in combining banking and private equity investing. The results are consistent with many of the worries about these transactions articulated by policymakers. Key concepts include:
  • The cyclicality of bank-affiliated transactions, the time-varying pattern of the financing benefit enjoyed by affiliated deals, and the generally worse outcomes of these deals done at market peaks raise questions about the desirability of combining banking with private equity investing.
  • These investments seem to exacerbate the amplitude of waves in the private equity market, leading to more transactions at precisely the times when the private and social returns are likely to be the lowest.
  • Investments involving both affiliated and nonaffiliated firms appear particularly vulnerable to downturns.
  • Some information-related synergies, however, are captured internally by the banks. But banks' involvement poses significant issues as well.
  • The share of banks in the private equity market is substantial. Between 1983 and 2009, over one-quarter of all private equity investments involved bank-affiliated private equity groups.
Read more at the National Post 

2 comments:

Anonymous said...

“Always mistrust a subordinate who never finds fault with his superior.”–J.C. Collins

Anonymous said...

A noble thought, full of the generosity of forgiveness and sense of "fair play" that marks the British middle class. Alas, however, it is sharply at odds with the political and bureaucratic realities of the American military establishment.

The US military has long followed a doctrine whereby there are always far more qualified officers available than there are combat or staff billets to fill. And at the higher ranks especially a mistake, no matter how trifling to outside eyes, generally means the end of career. Your destroyer runs aground on an uncharted sandbar? Doesn't matter if it was some junior's mistake - ultimately it means retirement for the Captain. He "failed to establish an atmosphere of training excellence" - or some other such military jargon.

McChrystal already got at least two "passes" on this policy: the mishandling of the Pat Tillman incident, and the leak contradicting VP Biden last fall. The senior command of the military simply will not nominate, and would strongly advise against, any appointment of McChrystal to further combat commands. Doing so would undermine the "up or out" promotion structure of the entire officer corps; and yet further weaken the credibility of the military's chain-of-command.